Download Public Policy and Private Investment in Pakistan

Public Policy and Private Investment in Pakistan
Shabib Haider Syed and
Muhammad Tariq Majeed1
Abstract
This paper analyzes the importance of government policy in
determining private investment in Pakistan. The empirical results show
that public sector investment, changes in bank credit to the private
sector and degree of capacity in the economy are playing an important
role in determination of private investment. The level of expected GDP
also positively affected the private investment, which is consistent with
flexible accelerator model. The results are also consistent with the
maintained hypothesis that public infrastructure investment is
complimentary to private investment; whereas other kinds of public
investment tend to be substitutes for private investment.
I.
Introduction
The accumulation of real physical capital stock has long been regarded as
one of the major factors in economic development. Fluctuations in investment
lead to significant changes on the functioning of an economy. More importantly,
in developing countries, private investment plays a greater role than public
investment in determining economic growth (Oshikoya, 1994; Naqvi, 2002). As
a result, a number of studies have been made to investigate the determinants of
private investment in developing countries (Abbas, 2003; Atukeren, 2005). The
changes in macroeconomic variables due to financial liberalization are likely to
modify the parameters of estimated investment functions, because relaxation of
credit constraints and increased influence of borrowing costs both affect the
investment decisions (McKinnon and Shaw, 1973; Akkina and Celebi, 2002).
This study investigates the role and scope of public policy for private
investment in Pakistan. The study establishes a direct relation between
government policy and private investment. The empirical results provide
1
The authors are Associate Professor, Department of Economics, Forman Christian
College (A Chartered University), Lahore and Lecturer of Economics, Quaid-i-Azam
University, Islamabad, respectively. The views expressed entirely belong to the authors.
evidence that private investment in Pakistan is constrained due to variations in
the flow of credit to the private sector. In contrast to previous studies, we are able
to establish a quantitatively important role of public sector investment in the
process of private investment. This role depends on the way in which public
sector investment is introduced. It becomes fruitful only, when a clear distinction
is made between long-term/infrastructural and short-term/non-infrastructural
public investment. In either case the Pakistan government does appear to be in a
position to alter the pattern of private investment by changing its own investment
policy.
The rest of the discussion is organized as follows: section II provides
survey of some selected studies: section III explains the model and framework of
analysis; section IV introduces the dataset and the construction of variables,
Section V puts forward the main findings from empirical analysis. Section VI
consists of conclusion and policy implications of the study.
II.
Literature Review and Theoretical Framework
There is an abundant body of literature available on the empirical and
theoretical study of the investment process. In existing literature, some have
focused the investment problem by dividing it into two parts; public investment
and private investment (Khan and Kumar, 1997; Khan and Rheinhardt, 1990).
There are some recent studies that addressed only the issue of private investment
(Khan, 1988; Sakr, 1993; Looney, 1997).
The debate whether private investment and public investment are
complements or substitutes, has drawn the attention of researchers towards
infrastructure investment that has positive/negative impact on private investment.
The studies that mentioned a positive impact of public investment on private
investment and, a positive/negative relationship between infrastructure/noninfrastructure and private investment include Oshikoya (1994), Blejer and Khan
(1984), Cardoso (1993), Sakr (1993), Sasaki and Khan (2001), Erden and
Hocolcombe (2005), where as the positive case is observed by Looney (1997),
Akkina and Celebi (1992), and Everhart and Sumlinski (2001). The basic result
of these studies is that government investment plays a very important role in
determining the private investment; either it will crowd-in or crowd-out the
private investment.
Besides this, Everhart and Sumlinski (2001) concluded that private
investment will be reduced when higher debt service payments are involved. The
studies that investigated and confirmed a positive relation between private
investment and real GDP are Oshikoya, 1994; Looney, 1997; Sakr, 1993; Greene
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and Villanueva, 1991; Veemon and Charles, 1996; Akkina and Celebi, 1992;
Guimaraes and Unteroberdoerster, 2006; Cardoso, 1993; Maxfield and Pastor,
1999; Ramirez, 1994.
The availability of bank credit in developing economies is considered as a
major constraint in the way of private investment. Some important studies that
analyzed this relationship include Wai and Wong, 1982; Agosin, 1995; Sakr,
1993; Blejer and Khan, 1984; and Akkina and Celebi, 1992. These studies
concluded that a positive relation holds between change in bank credit and
private sector investment.
The cost of capital is another determinant of private investment which is
measured by real interest rate. Some studies like; Greene and Villanueva (1991)
and Mataya and Veemon (1996) support the hypothesis that private investment is
negatively related to real interest rate where as the empirical results of Guimaraes
and Unteroberdoerster (2006) do not support the above hypothesis but concluded
that capital cost has a negative short-run impact on the growth of private
investment.
III.
Model Specification, Variables and Data Sources
Blejer and Khan (1984) bring modification in flexible accelerator model to
incorporate institutional and structural characteristics of a developing economy.
By this modification, it becomes possible to assume that desired stock of capital
is proportional to expected output in the long run. This is a quite standard
formulation and can be rationalized by assuming that the underlying production
function has fixed proportion among factor inputs because factor prices are not
considered.
In this study we followed the approach suggested by Coen (1971). The
methodology follows the track suggested Blejer and Khan (1984). This approach
makes possible for private investment to vary with underlying economic
conditions and it is consistent with the flexible accelerator framework. The
response of private investment to the gap between desired and actual investment
is measured by the coefficient B. It is also assumed that the coefficient B will
vary systematically with economic factors that influence the ability of private
investors to achieve the desired level of investment. The study hypothesizes that
the response of private investors depends on; the stage of the business cycle, the
availability of financing and the level of public sector investment.
During the expansionary phase of the cycle, demand conditions are
buoyant. The private investors are expected to respond more rapidly to changes
in desired investment. When trend or potential level of output is taken as an
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indicator of full capacity, then the reaction of investors to the discrepancy
between the desired and actual rates of investment would tend to be smaller if
actual output is above the full capacity. This will lead to more strain on available
resources and an increase in input prices. Alternatively, investment could respond
more rapidly in situations of excess capacity. It is, therefore, not entirely clear
what effect, on average, cyclical factors can be expected to have on the change in
private investment.
The effect of the availability of financing on the coefficient of adjustment
is less ambiguous. A clear consensus has emerged in recent years that, in contrast
to developed countries, one of the principal constraints on investment in
developing countries are quantity, rather than the cost of financial resources. The
rates of return on investment in these countries typically tend to be quite high,
whereas real interest rates on loan-able funds are kept low by government for a
variety of reasons. In such circumstances the investor cannot be expected to
equate the current marginal product of capital to its services cost. Indeed, these
countries are facing the problem of limited financing resources and price
mechanism that can’t operate smoothly, so it is legitimate to hypothesize that the
private investor is restricted by the level of available bank financing. Any effect
exerted by the rate of interest on private investment is not direct within this
rationing framework but, rather, occurs via the channel of financial savings.
An increase in real credit to the private sector will in general encourage
real private investment, and rolling over bank loans can sufficiently lengthen the
maturity of the debt. The role of foreign capital flows in the domestic investment
process, whether they are in the form of direct or portfolio investment has also
been documented by Wai and Wong (1982). The effects of foreign financing are
broadly similar to the effects of variations in bank credit; both tend to increase
investment because they expand the pool of financial savings. Since control on
volume and composition of bank credit usually is the principal instrument of
monetary policy in developing countries. Therefore, monetary policy has direct
and strong impact on the rate of private investment. In a similar vein, private
investment can be influenced by interest rate and exchange rate policies that
cause changes in the private capital flows, which augment or reduce financial
resources available to the private sector.
Finally, it is a well accepted proposition that in developing countries,
private and public investments are related. The public investment can cause
crowding out if it utilizes scarce physical and financial resources that would
otherwise be available to the private sector or it produces marketable output that
competes with private output. Furthermore, the financing of public sector
investment—whether through taxes, issuance of debt, or inflation--- will lower
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the resources available to the private sector and thus depress private investment
activity. But the public investment which is related to infrastructure and
provisions of public goods becomes complement to private investment. Public
investment of this type can enhance the possibilities for private investment and
raise the productivity of capital, increase the demand for private output through
increased demand for inputs and ancillary services, and augment overall resource
availability by expanding aggregate output and savings.
The overall effect of public investment on private investment, therefore,
depends on the relative strength of these various effects, and there is no a priori
reason to believe that they are necessarily substitutes or complements. Assuming
that the possibility of financial crowding out is taken into account by the
composite variable incorporating both the change in bank credit to the private
sector and private capital flows, our specific concern here is with real aspects of
public sector investment. If, on average, public and private investments are
substitutes, we would expect that the coefficient of adjustment of private
investment would become smaller as the rate of public investment increases;
conversely, complementarity would imply a faster response of private
investment. Again, this allows us to relate private investment behavior to
government policy, in this case given by changes in government capital
expenditures.
3.1.
The Model
On the basis of arguments mentioned above, we can express the
coefficients of adjustment as a function of cyclical factors and monetary and
fiscal policy variables. A linear representation of this relationship can be as
follow:
Bt = b0 + 1/(I*t –It-1) (b1 GAPt + b2 dDCRt + b3 GIRt + b4 RIRt)
(1)
Where:
Bt = Coefficient of adjustment.
I*t = realized investment in time period t
It-1 = lagged investment
GAPt = cyclical factors, given by the difference between actual and trend
output.
dDCRt = change in real bank credit to the private sector plus real net private
capital flows.
GIRt = real public sector investment.
RIRt= real interest rate.
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The coefficient of adjustment (Bt) depends on both the level (GIR) and the
change in public sector investment (dGIR), with the effect of the change in public
investment considered to be ambiguous. The strict accelerator (b0) expected to be
positive and closer to unity in the long run. This result would ensure that in the
steady state the capital output ratio would be constant. The effects of government
policy on private investment can be directly obtained from the estimates of b2, b3
and b4. The coefficient b4 expected to be positive and b3 can be negative or
positive; negative in the case of real crowding out and positive in the case of
crowding in.
An alternative approach is used to make the distinction between kinds of
public investment whether it is expected or not. When expected public
investment is closer to the long-term component then it exerts a positive
influence on private investment, where as the effect of the unexpected or surprise
component is uncertain. To calculate expected real public investment we used an
empirical method by fitting a first-order autoregressive process as below:
EGIRt = po+p1 GIRt-1
(2)
Where EGIRt is the expected real gross public sector investment, p0 is the
average level of real public sector investment and p1 is the auto regressive
parameter.
The list of variables used in the model includes; government investment
(IG), private investment (IP), change in domestic credit of the banking system to
the private sector (∆DCP), real interest rate (RINT), real gross domestic product
(YR), trend value of real GDP (TYR), deviation of real GDP from its trend value
(GAP), trend value of real gross public sector investment (TGIR), expected real
gross public sector investment (EGIR) and δ is the rate of depreciation.
IPt [1- (1- λ )(1 + g ) L] = λb0 a[YRt -1 -(1- δ )YRt -2 ] + [1- (1- λ )(1 + g ) L]
.[b1GAPt + b2 ∆DCRt + b3GIRt + (1- b0 ) IPtt −1 ]
IPt [1- (1- λ )(1 + g ) L] = λb0 a[YRt -1 -(1- δ )YRt -2 ] + [1- (1- λ )(1 + g ) L]
.[b1GAPt + b2 ∆DCRt + b3GIRt + b4 ∆GIRt + (1- b0 ) IPtt −1 ]
IPt [1- (1- λ )(1 + g ) L] = λb0 a[YRt -1 -(1- δ )YRt -2 ] + [1- (1- λ )(1 + g ) L]
.[b1GAPt + b2 ∆DCRt + b3TGIRt + b4 (GIRt − TGIRt ) + (1- b0 ) IPtt −1 ]
IPt [1- (1- λ )(1 + g ) L] = λb0 a[YRt -1 -(1- δ )YRt -2 ] + [1- (1- λ )(1 + g ) L]
.[b1GAPt + b2 ∆DCRt + b3 EGIRt + b4 (GIRt − EGIRt ) + (1- b0 ) IPtt −1 ]
(3)
(4)
(5)
(6)
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This study used annual data series for the period 1970 to 2004 for
Pakistan. The data series are collected from Handbook of Statistics on Pakistan’s
Economy, World Development Indicators (WDI), Economic Survey of Pakistan
(various issues) and International Financial Statistics (IFS). All nominal data
series are converted into real by deflating them with GDP deflator.
IV. Estimation and Empirical Results
The study used annual data series for the period of 1970-04 for the
estimation equations (3) to (6) for Pakistan’s economy. Ordinary Least Square
(OLS) technique is used for estimation and results are presented in the following
table 1.
Table: 1. Determinants of Real Private Investment
Parameters
Equation (4)
Equation (5)
131.66*
-205.0
-103*
-205
dYRt-1
∆DCRt
IPt-1
0.12*
0.33*
0.17*
0.19*
0.12*
0.35
0.13**
0.07*
0.30
0.19*
0.12*
0.35
GIRt
-0.74*
0.29
-
-
RINTt
-6.66
-
-
-
GAPt
∆GIRt
-
-0.0136*
-0.69*
-0.08*
-0.01*
-
TGIRt
-
-
0.12
-
GIRt- TGIRt
-
-
-0.13*
-
EGIRt
-
-
-
0.43*
GIRt- EGIRt
R2
Adj R2
0.96
0.95
0.99
0.99
0.98
0.98
-0.40*
0.99
0.99
DW
2.31
1.87
1.65
1.86
F Stat
149
679
379
679
Constant
Equation (3)
Equation (6)
*, ** shows 1% and 5% level of significance respectively.
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The real private investment is dependent variable of all four equations. The
results of equation (3) show that all variables are having expected sign and
significant except real interest rate, that is used as proxy for the cost of financing
investment. The increase in real GDP and lag value of private investment will
bring an increase in private investment. The results also predict that increase in
gross public investment will reduce the level of private investment. This implies
that private investment and public investments are substitute as predicted by
Akkina and Celebi (1992), Sasaki and Khan (2001), Everhalt and Sumlinski
(2001) and, Erden and Hocolcombe (2005).
The empirical results also revealed that change in domestic credit of
banking sector to private sector will positively affect the level of private
investment. If the over all quantity of financial resources is given, then any
attempt by the government to increase its share of either domestic or foreign
financing at the expense of private sector would lead to crowding out and decline
in the level of private investment. A decline would most likely lead to a fall in
total investment. As the control over domestic credit is the major tool of
monetary policy, this would be important for the real sector’s response to
changes in monetary policy. These results are consistent with the findings of Wai
and Wong (1982), Blegir and Khan (1984), Agosin (1995) and Sakr (1993). The
coefficient of trend in real interest rate variable is in-significant but has expected
negative sign. These findings are corroborated with finding of Guimares and
Unteroberdoerster (2006).
The equation (4) results are almost the same except that the coefficient of
lagged value of private investment becomes insignificant and two more variables
are introduced in this equation which are having negative signs and also
significant. The coefficient of deviation of real GDP from its trend value
indicates that one unit deviation of GDP from its trend value will inversely affect
the level of private investment. This also supports the hypotheses that private
investment is positively related to the degree of capacity in the economy. It
shows the constraint of resource availability when output is above its natural
level. The coefficient of second variable, change in gross real public investment
shows that change in it will inversely affect the private investment. These results
imply that the level of public sector investment has a positive effect on private
investment, where as the change in government investment has a negative effect.
On the basis of these results, it could be argued that it is not the level of public
investment that crowds out the private sector investment rather; it is the change
in public investment that appears to have strong crowding out effect.
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In equation (5), we introduced two more variables; trend value of real
gross public investment and the gap between gross real public investment and its
trend. The coefficient of first newly introduced variable is in-significant but
second has significant t-value. The behavior of all other variables remained
almost same as in previous equations (3) and (4). In equation (6), we introduced
two more variables; expected gross real public investment and the gap between
gross real public investment and expected gross real public investment. Both
variables are significant but expected gross real public investment has positive
impact and the variable named, gap between gross real public investment and
expected gross real public investment has negative impact.
These last two equations’ results are the most interesting from the point of
view of the empirical relationship between public and private investment in
Pakistan. The estimates of equation (5) indicate that the trend component of real
public investment exerts a positive influence on the level of real private
investment; where as deviations from the trend have the opposite effect. The
results are consistent with the maintained hypothesis that public infrastructure
investment is complementary to private investment; where as other kinds of
public investment tend to be substitutes for private investment. The same pattern
is apparent in the estimates for equation (6), where the distinction is made
between the expected and unexpected component of pubic sector investment.
Here an expected increase in public sector investment would raise the rate of
private investment, but an unexpected increase would have adverse effect on
private capital formulation.
All other parameters for all four models like; R2, Adjusted R2 and DW
Stat. indicate that all these performed well and relevant results are reliable for
policy implications.
V.
Conclusion and Policy Implications
This study shows that tight monetary policy has negative effect on the
level of private investment and economic growth as it reduces the availability of
real credit to the private sector. Moreover, attempts made by the public sector to
increase its share of domestic financial resources should be discouraged as it
would crowd out the private investment. The same is the case with the foreign
financing and public borrowing. It is suggested that government should increase
the infrastructure investment and reduce non-development expenditure, since
infrastructure provides sound foundations for new investment.
108
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